Blunting the effect of 'ipso facto clauses' – a reasonable interference with freedom of contract?

22 October 2018

Blunting the effect of 'ipso facto clauses' – a reasonable interference with freedom of contract?

The Government has announced that it will legislate to prohibit the enforcement of certain contractual termination clauses ('ipso facto clauses').

As with other aspects of the response to recent insolvency and corporate governance consultations, this has given us pause for thought.

The prohibition is to apply to rights of termination that could otherwise be exercised upon a counterparty's entry into one of the existing corporate insolvency procedures or either of the newly proposed restructuring tools (being a moratorium and a restructuring plan). Widening this further (and introducing something of an anti-avoidance element), it would appear that the prohibition is also to apply to grounds for termination "connected with the debtor company's financial position" that could otherwise be exercised on or following (but not before) the occurrence of a trigger event described above.

The impact of the proposal

The proposal is interesting in a number of ways. One is that it eschews an opportunity to expand the concept of 'essential supplies' in favour of an alternative approach. The continued provision of utilities and IT to a company that has entered administration, or in relation to which a CVA takes effect, and certain relief from forfeiture of a lease and actions to recover rent allowed to a company subject to an insolvency process, are already mandated by statute. Other 'essential supplies' might have been added to this list - whether hard-wired by legislation or (as proposed in the Government's 2016 consultation) designated by the relevant recipient. However, a view has formed that more substantial (or, at least, consistent) assistance to businesses in restructuring would be provided by a blanket regime in which, subject to specific exemptions, "contracts for the supply of goods and services" may not be terminated on the grounds mentioned above.

Suppliers would remain able to terminate on any other ground available to them. Perhaps most importantly, a non-payment event could be invoked (in relation to supplies made following the trigger point), but this will comfort only those suppliers with reasonably short payments terms - something that is far from a given in many sectors.

Contracts for certain financial services are to be exempted, which seems sensible given the countervailing risk of the plug being pulled on crucial working capital and other debt facilities ever earlier to avoid the effects of the prohibition.

Just as significant - and possibly more controversial - is the decision not to bring licences issued by public authorities in scope. Though not contractual in nature, the revoking of these licences in insolvency is often the death knell for businesses seeking to trade through a period of financial distress. It is a shame that the fomenting of a 'rescue culture' through the Government's proposed reforms in other areas will likely have negligible impact in such cases.

Protecting the supplier

It will also be interesting to see how, on a technical level, the legislation treats ipso facto clauses that are in scope of the prohibition. Will they be void or simply unenforceable? Will it still be advisable to include them in contracts, on the basis that: (a) for more generic termination events connected to the counterparty's financial position, these could still be permissibly invoked prior to a trigger event; (b) even termination events triggered by a counterparty's entry into an insolvency or restructuring process might be sanctioned on application to court (on which, see below); and / or (c) the inclusion of a prohibited ground for termination will be necessary for liabilities accrued to the supplier to be given priority as expenses of any moratorium, administration or liquidation?

Building on existing rules which provide for liabilities that arise during an insolvency process under an obligation to which the company was subject before entering insolvency to rank as expenses of the insolvent estate, it is to be hoped that the availability of the protection described in (c) above will not turn solely on the idiosyncrasies of individual clauses in contracts and be more widely legislated for.

Should it be available, this priority position may provide material comfort to many suppliers forced to continue supply to an insolvent or otherwise restructuring counterparty, but it is not an assurance that they will be paid in accordance with normal payment terms and, for some, the adverse effect on cash flow could be too severe. That is why, as a "safeguard of last resort", a supplier that is significantly adversely affected by not being able to invoke a specific termination clause will be able to apply to court for permission to so rely and terminate supply. It would have to be more likely than not that the supplier would enter an insolvency process as a consequence of continuing supply. This is a high bar, but is still an expansion of the protections currently available to 'essential suppliers' and landlords.

The bigger picture

Sitting above all of this is a matter quite fundamental to English contract law. The Government acknowledges that its preference for a prohibition on ipso facto clauses was motivated, at least in part, by this approach being common among a number of jurisdictions with highly-ranked insolvency regimes (as judged by the World Bank's Doing Business methodology). Chief among these is the US Bankruptcy Code, which applies a regime that, in some respects, may be even more intrusive than what comes to pass in the UK. However, even taken at its lightest, the Government's proposal is a noteworthy curtailment of freedom of contract. Intriguingly, the same has been said of The Business Contract Terms (Assignment of Receivables) Regulations 2018, which are expected to be made this autumn. Those regulations prohibit contractual provisions that restrict the assignment of certain receivables, with the intention of widening access to receivables financing.

English lawyers are naturally suspicious of any interference with freedom of contract, such that, when in force, the impacts of these developments will be closely observed for the measurable benefits they will need to deliver to struggling businesses in order to be considered a success.